Due to the high cost of medical care and services, it’s wise to think through the best medical coverage options for you and your family. Health insurance premiums vary from state-to-state, provider-to-provider, and person-to-person. Some plans are cost efficient and cover a wide range of services while others are expensive with limited coverage. Not only that, but changes to healthcare plans can be unpredictable, especially as you age.
One option to consider is a Health Savings Account, or HSA. HSA’s are pre-tax savings accounts used to cover qualified medical expenses. To see what qualifies under HSA regulations, click here to visit the IRS website.
As of 2019, you can contribute up to $3,500 annually for individuals or $7,000 for families to an HSA. If you have an HSA through your employer and elect to also open an individual HSA for yourself, the contribution for both accounts combined is still $7,000. Unlike FSA’s (Flexible Spending Account), this money does roll over from year to year, and it earns interest.
Another benefit of an HSA is what’s commonly referred to as the triple tax benefit. First, contributions are tax-deductible, which lowers your overall tax burden. Second, the interest earned on your account grows tax-deferred. And third, the money you withdraw is tax-free as long as it’s used for qualified medical expenses. If you choose to withdraw funds for purposes other than qualified medical expenses, then those dollars will be considered taxable income. Not only will those dollars be taxed, but you could also be hit with a 20% penalty. That’s a little different than a 401(k) or an IRA, where you could get hit with taxes, plus a 10% penalty.
So, if you put money into an HSA, you need to spend it only on qualified medical expenses. However, once you reach 65, you can withdraw the money for any reason without paying the penalty. If you withdraw it after age 65 for medical expenses, you’ll still pay absolutely no taxes. If you withdraw the money after age 65 for any other reason, you’ll only pay income taxes and no penalties apply. Since HSA funds rollover from year-to-year, there is no disadvantage to maxing out your annual contributions even if you don’t anticipate using the full amount because once you turn 65 those funds can be rolled into an IRA and withdrawn with the same tax treatment as a withdrawal from your 401(k).
DON’T BE SCARED OFF BY THE HIGH DEDUCTIBLE REQUIREMENT
In order to qualify for an HSA, you must have a high-deductible health insurance plan. The definition of high-deductible plan may vary a little depending on where you live, but for the most part it’s considered $2,700 for families and $1,350 for individuals.
This point may cause concern. After all, why pay a higher deductible plus contributions to an HSA when you can just have a low deductible and spend that $7,000 per year elsewhere?
Fair question.
To answer it, you need to examine the full financial picture.
Let’s say you are choosing between an HSA + insurance plan with a $2,700 deductible, or no HSA and an insurance plan with a $500 deductible. First, consider the tax savings from contributing $7,000 to the HSA compared to zero tax benefit with the low deductible plan. For convenience sake, let’s assume you have a 40% tax rate (state, federal, and FICA taxes), then you would save $2,800 for the year, which is more than the difference in deductibles, which is $2,200. And remember, this is a tax benefit you receive every year.
Conversely, imagine if you went with the low-deductible plan and no HSA. Each year you would miss out on the $2,800 tax benefit in order to save $2,200 (the difference between the two plans). Stretch that out over a ten-year period, and you will pay an additional $28,000 in taxes ($2,800 x 10) by missing out on HSA contributions, plus, assuming you hit your deductible every year, $5,000 in medical expenses, which were paid with post-tax dollars ($500 x 10).
However, over that same ten-year period with the high-deductible plan + HSA, assuming you hit your deductible each year, you would pay $27,000 in medical costs ($2,700 x 10), while gaining the tax savings of $28,000 ($2,800 x 10). That’s a net gain of $1,000, while the low-deductible plan would result in a net loss of $5,000 on top of the $28,000 lost in tax benefits.
HSA’s USE PRE-TAX DOLLARS
Also, by contributing to an HSA, medical expenses are paid with pre-tax dollars instead of after-tax dollars during those years. If you were to go with the low-deductible plan mentioned above, you would pay $500 out of pocket with after-tax income. If you chose the high-deductible + HSA, contributions and tax-deferred growth from investment gains on the balance can be withdrawn tax-free to pay for your medical expenses. In the 10-year example above, the $27,000 in medical expenses under the HSA-eligible plan would be paid with gross income, whereas the $5,000 in medical expenses under the low-deductible plan would be paid with after-tax income.
HSA’s BENEFIT THE YOUNG AND HEALTHY
If the high-deductible requirement is still a concern, it may help to be reminded that those who are still fairly young and in good health will most likely never come close to their deductible from year-to-year, which makes the high-deductible + HSA an even more lucrative option. The less you spend on medical services, the less you withdraw from your account, allowing those dollars to grow with the market.
HSA BALANCES CAN BE INVESTED
Still not convinced? Consider this: the balance of your HSA (which, as mentioned above, rolls over each year) can be invested so that it will grow over ten, twenty, or thirty years and be withdrawn tax-free to pay for medical expenses. Typically, with investment accounts, contributions are made with after-tax dollars but the investment growth can be withdrawn tax-free. Or, contributions are made with pre-tax dollars while growth is tax-deferred and the dollars are taxed as income when withdrawn. Investment contributions can also be made with after-tax dollars and the investment growth is taxed at capital gains tax rates when withdrawn.
With an HSA, contributions are pre-tax and the growth is tax-deferred and the withdrawals are tax-free when used for medical expenses, which means both the money contributed and the gains are never taxed. Again, if you are young and health and rarely withdraw funds from your HSA, the account could have a great deal of growth over the years, which means market gains that never incur a tax are paying for a substantial portion of your healthcare.
HSA’s AND LONG-TERM CARE
You can also use your HSA to pay for Long-Term Care premiums, which, as we’ve written before, are costly. Long-Term Care policies pay for home health care, hospice, adult day care, assisted living, nursing home care, among other things. Long-Term Care premiums qualify as a medical expense, so you essentially pay the insurance premium with pre-tax dollars, which then buys a policy that pays a tax-free benefit for the care you would expect to pay for at some point in the future. In 2019, people who were 40 or younger could withdraw up to $420 tax-free from an HSA to pay their long-term-care premiums. People age 41 to 50 can withdraw $790, those age 51 to 60 can withdraw $1,580, those age 61 to 70 can withdraw $4,220, and if you’re 71 or older you can withdraw $5,270. Just another way those dollars can go even further and prevent you from using after-tax dollars from your nest egg in the future.
As you can see, the benefits of a Health Savings Account are vast. If you are interested in speaking to one of our advisors about setting one up, click the button below.
